Can the Fed Find the Sweet Spot?

The questions of the day seemed to revolve around Fed policy, the US trade
deficit and the dollar. We look at all of these questions and more in today's
letter. Specifically, I want to try to lay out three scenarios involving future
Fed policy actions and what each possibility might mean for the US and global
economies.

Can the Fed Find the Sweet Spot?

The Fed is in an extraordinarily difficult position. Some very distinguished
observers believe the Fed should stop their tightening cycle now. Others think
that not only should they keep hiking rates at a measured pace, they should
continue to do so for the rest of the year (for a variety of reasons). Raising
rates too much or too little each bring their own set of problems. But it is
not altogether clear what the appropriate level of short term interest rates
should be, and even if we found that appropriate level, it is not clear that
the results would be what was first intended.

Indulge me for a few paragraphs, while I use a golf analogy. The technology
of golf clubs has improved over the years. But every club whether a hundred
years old or fresh off the shelf has one thing in common. They have been designed
with a "sweet spot." The sweet spot is that point on the club face that if
you hit it square the ball will fly straight and true. Every golfer has had
that moment of sublime bliss when he catches the ball just perfectly. There
is something about a 250 yard down the middle drive that is simply good for
the soul. Unfortunately, for most golfers, those are rare events.

The pros, who hit tens of thousands of practice balls a year, regularly find
the sweet spot. The rest of us just struggle, but every now and then we hit
the shot that brings us back to the golf course the next week. But hitting
the sweet spot doesn't necessarily guarantee a positive outcome.

I remember the first time I played the beautiful Castle Harbor course in Bermuda.
The course is very hilly, with lots of "blind shots." If you don't have a little
course knowledge you can easily get into trouble. My partner was a local, who
soon recognized that my game was not very good. I earn my 29 handicap the hard
way. As we came to one par five, I hit a reasonable drive, but found myself
in a valley with a very difficult downhill, side-hill lie and the next shot
over a hill to a spot I could not see. Even for pro it was daunting. But you
have to hit them where they lay.

I asked my partner where I should aim, and he casually waved, "that way." The
golf gods decided to have fun at that point, and I hit one of the better shots
of my life. My partner gave me a funny look and said, "You may be in trouble.
I didn't think you could hit it that good." Sure enough, I was in the water,
and eventually had a bogey four.

A few years later, I was playing the Nicklaus Course in Cabo San Lucas. The
16th hole (I think) is a beautiful par three on the ocean, with tall cliffs
to your left. Again, you are hitting over a hill to a green you can't see.
You don't know where your ball lands until you get over the rise. My two partners
hit their balls straight and true at the green. I proceeded to badly pull two
balls (for your purists, the second was a provisional) into the exact same
place in the mountain on the left, and picked up my tee in disgust, deciding
to stop sacrificing new balls to the golf gods.

I rather dejectedly got back into the golf cart and drove over the hill. To
everyone's surprise there were four golf balls on the green, one less than
two feet from the hole. We all wondered who hit the lucky shot, and where did
those extra golf balls come from? We had watched my balls go into the side
of the mountain. As it turned out, I hit the right spot on the mountain which
funneled my balls as the rolled down right to the hole, both ending up closer
than the two shots of the far superior golfers who had found the sweet spot.
(For the record, the first ball was the closest.)

Of course there are the rare times when I hit the ball perfectly and actually
get a perfect result. The more you practice, the more likely you are to hit
the ball on the sweet spot and get a good result. The more familiar you are
with the course, the more likely you will choose the right club and direction
to aim the ball.

Now what does that have to do with the Fed? The Fed is like an amateur golfer
who is down in the valley, getting ready to hit a blind shot. Their partner,
Mr. Market, is vaguely saying hit the ball "that way." What club should they
use? Can they find the sweet spot, and if they do, where will the ball end
up?

Now, some might find it harsh of me to suggest that the Fed might be amateurs.
After all, they are some of the best and brightest economists of our generation.
I truly have a great deal of admiration for many of them, if only through their
speeches and papers.

But they are like the golfer, even a gifted athlete, who has had a great deal
of instruction and not much actual playing time. But John, some will suggest,
the Fed has been doing this for years. I would suggest that not with these
set of circumstances. What worked in 1990 or 2001 might not be appropriate
today. But how would we know? They have had no real experience with this course.
They may know what their clubs will do with a given set of circumstances, but
they are hitting blind.

They have had multiple coaches who have all given them the one secret "swing
thought" guaranteed to produce a perfect shot.

"Use the Taylor Rule. No, you should be thinking about the natural rate. If
you just focus on inflation everything else will work out. The most important
thing to do is pay attention to the bond market. The most important thing to
do is pay attention to the stock market. Make sure you don't get too close
to deflation. Don't let another asset bubble develop in the housing market.
Your primary focus should be on jobs. Think about the dollar, trade deficits
and on and on." And every "coach" is loaded with academic papers proving that
their approach is the correct one.

What's a poor Fed governor to do? Just like that difficult and unfamiliar
course in Bermuda, the Fed is now in a period without any real historical analogy.
They are hitting blind. They understand the fundamentals as well as anybody.
It's just not altogether clear which approach is best. The simple fact is they
have to use their best guess at which theory is appropriate for today and step
up and hit the ball. Then they have to get into the golf cart of time, go over
the hill and see where the ball landed.

The Fed funds rate is now at 3%. It is almost certain that the Fed will raise
another 25 basis points at its June meeting. The market in the form of Fed
futures suggests the Fed will raise another 50 basis points after that to 3.75%.

Today the 10 year bond settled at 3.98% after briefly touching 3.82%, because
the unemployment data disappointed the markets. (Quite the wild ride for the
boys in the pits.) As noted last week, Bill Gross suggests that the 10 year
is going to 3%, and Rosenberg of Merrill Lunch suggests we could see 3.5%.
If they are right, we would have an inverted yield curve if the Fed raised
short term rates to 3.75%. Another 75 basis points clearly seems like too much
to raise rates, doesn't it?

Maybe not. Richard Berner of Morgan Stanley, among many others, argues that
inflation is not yet tamed and lays out the data to demonstrate that increased
inflationary pressures are clearly evident. Unit labor costs are rising rapidly
and productivity is slowing which is something new. Such a trend suggests more
inflation in the pipeline. The bond market will surely come around in time
to understand this, he posits.

If you hold that view it would explain why Greenspan might think the bond
market is a conundrum. If inflation is increasing then long rates should be
rising. Right now, there are only 70 basis points between the 2 year and the
30 year bond: 3.57% and 4.28% respectively. With the ten year at 3.98%, the
difference is only 41 basis points. That is a very flat curve.

Whatever your position on Greenspan is, he has spent a career, and built his
reputation, as inflation fighter. Minutes from the FOMC meeting on May 3 released
last week also showed that the Fed's policy-setting committee was keenly aware
that inflation pressures had picked up.

Recent speeches by several Fed governors in the past few months have made
it clear that they are concerned about a new asset bubble in the housing market.
They would like to see rates rise to the point where the rise in housing prices
moderates considerably. Of course, this poses its own set of problems (see
below).

Historically, the Fed has tended to tighten for far longer and to a greater
degree than what most observers originally felt they would. They have been
nothing if not consistent in their fight against inflation. This is certainly
Greenspan's last year. Is it not unreasonable to ask why he would back off
in his fight against inflation at the end of his career?

Open the Flood Gates

And then there are those who argue that the economy is already weakening.
And that the Fed should pause in its interest rate hikes.

Last month's ISM is a perfect illustration. The ISM is a monthly barometer
of the activity as noted by the purchasing managers of manufacturing companies.
If the number is above 50, manufacturing is growing. The number for May was
51.4. But the trend is disturbing. Last year at this time the number was comfortably
above 60. Each month since then we have seen the number drop slightly. Last
month is dropped 1.9. Another such drop would put it below 50. The trend suggests
that will happen this summer.

Paul McCulley points out the Fed has never tightened when the ISM drops below
50. We could be nearing that point.

Newly appointed Dallas Fed Governor Richard Fisher in a recent speech suggested
that we are close to the end of the tightening cycle "We've gone through eight
innings here, 25 basis points an inning," Fisher told the Journal, referring
to the eight quarter-percentage point rate hikes made by the Fed since it began
hiking borrowing costs this time last year. "The next meeting in June is the
ninth inning. We'll take a look after that. We may have to go into extra innings
in this contest against inflation." (BW Online)

His comment was one of the reasons that interest rates on the long bond began
to drop. I'm not certain how much weight we should give to a newly appointed
Fed Governor; especially given the other Fed governors are suggesting that
the "measured approach" is still the watchword for the day.

Be that as it may, he may be right. Today's employment numbers disappointed
with only 78,000 new jobs. But it may be worse than that. Buried in the report
is something called the Birth/Death ratio. This is an effort by the Bureau
of Labor Statistics to guesstimate how many jobs were created by the private
sector in the last month. This month, the number was 205,000. But if the economy
is slowing down as the ISM number and other economic factors seem to suggest,
then 205,000 may be too high. Further, the B/D ratio for the last half of the
year is typically much, much smaller. In July, the number will likely be negative.

As I noted last week, the recent growth of the money supply has gone flat
line. This is not a good scenario for economic growth or for the stock market.

All of this suggests that when the Fed meets in August, the economic data
could be quite disappointing. A slowing economy, a poor manufacturing environment
and a weak jobs number might cause them to pause, especially if inflation pressures
seem to be backing off.

But what about those who argue that inflation is getting ready to come back?
There are even more who argue that inflation is under control and is likely
to begin heading down.

What are the risks of the above scenarios? If rates are raised too much it
could choke off the growth in the economy. Indeed as noted above, there are
reasons to think that the economy is already slowing.

However, if interest rates are too low, there is a risk that the economy could
become overheated and inflation pick back up. If indeed inflation did rear
its ugly head, it would in fact cause long rates to rise. If mortgage rates
were to rise, as noted above, it would have a serious impact upon the US economy.

This next little tidbit actually surprised me. "The economic consulting firm
Economy.com estimates that total cash raised from the mortgage equity withdrawals
exceeded $700 billion last year (8% of disposable incomes) up from $250 billion
five years earlier." (BCA Research).

My back of the napkin analysis suggests this was almost 6% of the total US
GDP. If you slow the rise in the value of the homes down too much or, God forbid,
you actually see a fall in home prices, it would suggest that mortgage equity
withdrawals would be greatly reduced. That would clearly have a negative impact
on economic growth, as consumer spending as financed by mortgage equity withdrawals
would slow down.

But if the housing market continues to rise at recent rates it becomes clear
at some point that we have another asset bubble. This is a bubble that if it
were to burst would have far more widespread consequences than the bursting
of the stock market bubble.

Thus the risks: too much tightening and we risk recession. Too little and
we risk inflation. Either are bad for the housing market and the economy.

Straight Down the Middle

Of course there is a scenario that the Fed is trying to pursue: they want
to hit it straight down the middle. They would like to see rates rise enough
to slow the rise in home prices, but not enough to choke off the market. They
would like to see rates stay low enough to help stimulate the economy if we
are indeed getting ready to go through what looks like a "soft patch."

If they can find the sweet spot, the current economic expansion, along with
a rising trade deficit could last for several years longer. It won't make the
problems go away, and indeed, the ultimate resolution may even be worse, but
in the short term life would go on.

Of course, the trick is to figure out what the right rate is. Where is the
sweet spot? Is it 3% or 3.5% or 4%? Should they pause after the June meeting
and then wait to see what happens to inflation and the economy before another
rate hike? Will they preemptively continue to raise rates wanting to drive
a stake in the heart of inflation?

Greenspan, in one of the finest speeches he has ever given, told us two summers
ago that the Fed has to take into consideration the possible negative impacts
of their decisions and weigh them more than the potential positive impacts. "First,
do no harm."

The world is still a disinflationary world, and a recession in the next year
would bring about a renewal of deflationary fears. If we were to enter a recession,
with inflation relatively low, very little potential for stimulus from lowering
rates and no potential stimulus from more tax cuts, it would be worrisome indeed.
The Fed would not have the deflation fighting tools it had in 2001-2002. To
use another golf analogy, it would be like playing with only 7 clubs rather
than the normal 14. While Tiger Woods could probably play almost as well without
a driver and a putter, it would be a serious handicap for the rest of us.

The clear front runner for the new Federal Reserve Chairman is Ben Bernanke.
He has made it quite clear that the Fed would be willing to use "unconventional
means" (remember the printing press?) to fight any potential deflation. This
is not a scenario that anyone wants to actually have happen.

I think the Fed will come to see that the preponderance of risk is that raising
rates chokes off the economic expansion. If inflation does become a problem
at some later date they can always raise rates at that time. In fact, dealing
with some future recession when inflation is higher than it is today would
actually make it easier to deal with any potential deflation.

So, you raise rates at the June meeting, and then see what the data from July
tells you at the August meeting. You change the language at the June meeting
to let everyone know that any future interest rate hikes are now determined
on a meeting by meeting basis. To use Fisher's baseball analogy, you call a
rain delay after the June meeting.

Will it work? No one knows. No one knows what the natural level of interest
rates should be. No one knows how all the myriad influences on the economy
will play out. And it is not altogether clear that even if the Fed hits the
ball on the sweet spot that it will land at a safe place. When you're hitting
blind, all you can do is drive over the hill and hope for the best.

This is why I would argue that we should more clearly define the role of the
Federal Reserve. If the Fed focused on steady growth of the money supply in
line with GDP, and the let the markets deal with the business cycle, we would
have less of this uncertainty. If the US government were to have some fiscal
discipline we would see our negative trade balance and other problems begin
to dissipate over time. But since that scenario is the least likely of any
I have painted, let's focus on what might likely happen.

I would give the first two scenarios a probability of 40% each, and the middle
scenario a probability of 20%. Finding the middle of the fairway when you're
hitting blind is a very difficult task. We are getting closer to the end game,
and I think the market realizes it. Each set of data is going to be seen as
more and more important. That is a scenario for more volatility like we saw
today.

Chicago, La Jolla and Surf's Up, Dude

I will be in Chicago for a brief visit next week to meet with clients at a
dinner hosted by my partners at Altegris Investments. I may also get to go
by the Merc for lunch on Wednesday and then back home. I am way behind on a
few projects that I really need to catch up on over the summer, not the least
of which is a complete re-write and re-work of my various web sites. I need
to have those reflect our new international partnerships which deal with accredited
investors and alternative investments such as hedge funds. We will be announcing
an association with a Canadian firm this month and expect within a few months
to have one with a firm that we will partner with in Latin America and Asia.
We already have an associated group in Europe (Absolute Return Partners)

The first two scenarios above pose issues for the broader bond and stock markets,
in my opinion. My personal and professional approach is to look for appropriate
alternative investments. If you are an accredited investor (basically $1,000,000
net worth or more -- see web site for complete details) I invite you to go
to www.accreditedinvestor.ws and
sign up for my free letter on hedge funds. I work closely with Altegris Investments
in the US (and my international partners worldwide) to find and offer a variety
of alternative investments, hedge funds and commodity funds. To find out more
simply click on the link above. (In this regard, I am president of and a registered
representative of Millennium Wave Investments, member NASD. See the important
disclosures below.)

In two weeks I will be in La Jolla where my youngest son will be surfing and
Dad will be meeting with clients, potential clients and my partners at Altegris.
We are setting meeting times now, so let us know if you are interested in meeting.

It is time to hit the send button. This is going to be a busy weekend. It
was nice to relax on Memorial Weekend, but I really have to get a lot done
in the next few months. The good news is that except for the lawyers, I really,
really enjoy what I do. (Don't get me wrong. I like my lawyers personally.
It is just the time and money and absurdities of this business that drive you
nuts.) I am having more fun than I have ever had at any time in my life, and
I thank you for allowing me into your computer. Have a great week.

Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA)
a registered investment advisor. All material presented herein is believed
to be reliable but we cannot attest to its accuracy. Investment recommendations
may change and readers are urged to check with their investment counselors
before making any investment decisions. Opinions expressed in these reports
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